Guidance issued on payments to charitable organizations
Proposed regulations issued by the IRS on Friday provide guidance on the treatment of payments made to charitable organizations in return for consideration, including in return for state and local tax credits (REG-107431-19). The regulations incorporate two earlier pieces of IRS guidance, Rev. Proc. 2019-12 and Notice 2019-12, as well as addressing other issues. The proposed regulations provide further guidance on the issue of states’ and taxpayers’ attempts to avoid the $10,000 cap on state and local tax deductions by making charitable contributions instead (see T.D. 9864). The IRS says it received over 7,700 comments on the topic after issuing proposed regulations (REG-112176-18) in August 2018.
The new proposed regulations make updates to the current Sec. 162 regulations to reflect statutory changes regarding how Sec. 162 applies when taxpayers make a payment to a Sec. 170(c) charitable organization for business purposes. They also provide safe harbors under Sec. 162 for payments made by businesses to Sec. 170(c) organizations and under Sec. 164 for payments made to a Sec. 170(c) organization by individual taxpayers who itemize and receive (or expect to receive) a state or local tax credit in return for the payment. Finally, they update the regulations to reflect past guidance and case law on the application of the quid pro quo principle under Sec. 170 to benefits received (or expected to be received) by a donor from a third party.
Payments by businesses in exchange for tax credits
As for the first issue — how business entity payments are treated — the proposed regulations would amend Regs. Sec. 1.162-15(a) to more clearly reflect the current state of the law regarding a taxpayer’s payment or transfer to a Sec. 170(c) entity. If the taxpayer’s payment or transfer bears a direct relationship to its trade or business, and the payment is made with a reasonable expectation of commensurate financial return, the payment or transfer to the Sec. 170(c) entity may constitute an allowable deduction as a Sec. 162 trade or business expense rather than a Sec. 170 charitable contribution. A proposed example illustrates that this rule applies regardless of whether the taxpayer expects to receive a state or local tax credit in return. This rule applies to C corporations as well as passthrough entities.
The proposed regulations incorporate a safe harbor originally issued in Rev. Proc. 2019-12. Under this safe harbor, to the extent a C corporation or specified passthrough entity receives or expects to receive a state or local tax credit in return for a payment to a Sec. 170(c) organization, the IRS believes it is reasonable to conclude that there is a direct benefit and a reasonable expectation of commensurate financial return to the entity in the form of a reduction in the state or local taxes the entity would otherwise be required to pay. The safe harbor allows a C corporation or specified passthrough entity engaged in a trade or business to treat the portion of the payment that is equal to the amount of the credit received or expected to be received as meeting the requirements of an ordinary and necessary business expense under Sec. 162. The safe harbor applies only to payments of cash or cash equivalents.
A specified passthrough entity, for this purpose, is a business entity that is separate from its owners for all federal tax purposes, that operates a trade or business under Sec. 162, is subject to state or local taxes incurred in carrying on the trade or business and that are imposed directly on the entity, and that, in return for a payment to a Sec. 170(c) organization, receives (or expects to receive) a state or local tax credit that the entity applies (or expects to apply) to offset a state or local tax other than state or local income tax.
These rules would apply to payments made on or after the date the proposed regulations are posted in the Federal Register (scheduled for Dec. 17, 2019), but taxpayers may continue to apply Rev. Proc. 2019-12, which applies to payments made on or after Jan. 1, 2018.
Payments by individuals in exchange for tax credits
The proposed regulations also incorporate a safe harbor the IRS issued last June in Notice 2019-12. Under this safe harbor, an individual taxpayer who itemizes deductions and makes a payment to a Sec. 170(c) entity in exchange for a state or local tax credit may treat as a payment of state or local tax for Sec. 164 purposes the portion of that payment for which a Sec. 170 charitable contribution deduction would be disallowed under Regs. Sec. 1.170A-1(h)(3). This treatment is allowed in the tax year in which the payment is made, but only to the extent that the resulting credit is applied under state or local law to offset the individual’s state or local tax liability for that or the preceding tax year. Any unused credit permitted to be carried forward may be treated as a payment of state or local tax under Sec. 164 in the tax year or years in which the carryover credit is applied.
This safe harbor is proposed to apply to payments made on or after June 11, 2019 (the date Notice 2019-12 was issued); however, taxpayers can rely on the proposed regulations for payments made after Aug. 27, 2018.
Consideration provided by a third party
Under Regs. Sec. 1.170A-1(h)(1), a payment that a taxpayer makes to a Sec. 170(c) charitable organization that is in consideration for goods or services is not deductible except to the extent the payment exceeds the fair market value of the goods or services. Commenters raised the question of whether the Prop. Regs. Sec. 1.170A-1(h)(3)(iii) interpretation of the definition of “in consideration for” in Regs. Sec. 1.170A-13(f)(6) left open the possibility that consideration provided by a third party is disregarded when calculating a charitable contribution deduction.
The proposed regulations would amend Regs. Sec. 1.170A-1(h) to make it clear that the quid pro quo principle applies regardless of whether the party providing the quid pro quo is the donee or a third party. In either case, the donor’s payment is not a charitable contribution to the extent the donor expects to receive a substantial benefit in return. These proposed changes would apply to payments made on or after the date the proposed regulations are published in the Federal Register.